The National Defense Authorization Act of 2013 (“NDAA”), which the President signed into law on January 3, 2013, includes significant reforms to the rules for contracting with small businesses. The reforms are relevant to small and large businesses alike, as they change the rules these businesses must follow when teaming together for government contracts.

Commenting on the NDAA, House Small Business Committee Chairman Sam Graves (R-MO) stated: “The small business provisions in the NDAA will help make sure existing small business goals are actually met, empower small business advocates, and crack down on fraud…These reforms will help small businesses compete in the federal marketplace, bring efficiency and cost-savings to the taxpayer, and create jobs while doing it.” The full impact of the NDAA will not be known until the Small Business Administration (“SBA”) issues regulations mandated by the NDAA.

Below are some of the more significant changes in the NDAA with regard to small business issues.

Mentor-Protégé Program

Section 1641 of the NDAA mandates a significant expansion of the SBA’s Mentor-Protégé program. Under present SBA regulations, the “protégé” in an SBA-approved mentor-protégé relationship must be a participant in the 8(a) program. A key benefit of the current mentor-protégé program is that it allows the protégé firms to form joint ventures with mentor firms of any size and still to qualify for 8(a) or small business status without triggering the SBA’s affiliation rules. The Small Business Jobs Act of 2010 (the “Jobs Act”) authorized the SBA to issue regulations creating similar mentor-protégé programs that would permit service-disabled veteran-owned (“SDVO”), woman-owned or HUBZone small businesses to qualify for protégé status.

The NDAA further expands the mentor-protégé program by permitting all small business concerns to qualify for protégé status. This newly-expanded program must function identically to the program established for the 8(a) companies. While the SBA has not yet issued regulations on the mentor-protégé program created in the Jobs Act, the NDAA directs the SBA to issue, subject to notice and comment, regulations pursuant to the even broader mandate of section 1641 within 270 days from the enactment of the NDAA. It is yet unclear whether the NDAA effectively has superseded the Jobs Act with regard to the mentor-protégé program, since the Jobs Act authorized three subcategories of small businesses to qualify for mentor-protégé status and the NDAA now has expanded that list to include all small businesses. It remains to be seen whether the SBA will issue one comprehensive set of regulations pursuant to the NDAA or will issue additional, specific regulations pursuant to the Jobs Act.

The further expansion of the SBA mentor-protégé program, once implemented, will benefit small and large businesses alike. Because the program currently allows only 8(a) firms to qualify as protégés, many would-be mentor companies have trouble identifying suitable protégés. Allowing all small businesses, regardless of 8(a) or other socio-economic status, to qualify as protégés will greatly increase the pool of available protégés and likely draw more large businesses into the program as mentors.

Limitations on Subcontracting

Section 1651 of the NDAA fundamentally changes the formula for calculating the limitations on subcontracting for contracts for services and, to a lesser extent, contracts for supplies. In separate ways, it both expands and constricts a small business prime contractor’s ability to outsource (subcontract) work under contracts set aside for small businesses.

Previously, SBA regulations and the implementing FAR clause (52.219-14, entitled “Limitations on Subcontracting”) required a small business prime contractor to perform with its own personnel at least 50 percent of the total direct labor on a small business set-aside contract for services. The regulations focused solely on labor and imposed no limitation on subcontracting for materials or other direct costs (“ODCs”). Section 1651 of the NDAA effectively repeals these regulations. It adds a new section 46 to the Small Business Act, which prohibits the prime from expending on subcontractors “more than 50 percent of the amount paid” under a contract to the prime contractor or “similarly situated entities.”

To illustrate: prior to the NDAA, the required limitation on subcontracting in services contracts could be expressed with the following formula:

Thus, for example, under the previous formula, if a contract for $15 million consisted of $10 million in labor costs and $5 million in materials, the prime was required to perform 50 percent of the labor, equaling $5 million dollars. It theoretically could expend the remaining $10 million on subcontractors ($5 million for labor and $5 million for materials).

The NDAA changes both the numerator and denominator of this formula. Under the new formula mandated by section 1651 of the NDAA, the numerator not only includes the prime contractor, but also “similarly situated entities.” A “similarly situated entity” is essentially defined as an entity in the same socio-economic category as the prime contractor (i.e., small business, 8(a), SDVO, HUBZone or WOSB). The apparent intent of section 1651 is that a small business prime contractor will be able to include in the numerator amounts paid to all other subcategories of small business concerns but that, for example, an 8(a) concern will be able to include only amounts paid to other 8(a) concerns, and SDVO firms can include amounts paid to other SDVO firms, and so on. Presumably, SBA regulations will clarify this provision. Per section 1651, the denominator in the calculation is the total amount paid under the contract, except in contracts for supplies, wherein the cost of materials is excluded. The intent of these changes is to make sure at least half of the revenue generated under a contract that is set aside for a particular socio-economic category – i.e., small, 8(a), SDVO, HUBZone or WOSB -- is paid to prime or subcontractors within that category.

As a result of the NDAA, the formula used to calculate the limitation on subcontracting in services contracts is the following:

Under this formula, assuming there is only one large subcontractor working with the prime and using the same example of a $15 million contract from above, the prime cannot expend more than $7.5 million on subcontracts to other-than-small businesses.

Unlike in other sections of the NDAA, section 1651 does not expressly direct SBA to issue regulations regarding the new limitations on subcontracting under services and supply contracts (although SBA likely will issue regulations on these provisions). For construction contracts, however, Congress directed the SBA Administrator to establish, through public rule-making, similar limitations on subcontracting requirements. For the time being, construction contracts therefore remain governed by the older formula.

Section 1652 of the NDAA provides that the penalty for violation of the limitation on subcontracting shall be the greater of $500,000 or the dollar amount expended, in excess of permitted levels, on subcontractors. This is a significant change to existing law, which provided no express penalties or other mechanisms to enforce the limitations on subcontracting rule.

Here again, the NDAA is likely to affect both small and large businesses alike. Prior to the NDAA, a large business subcontractor theoretically could earn more than 50 percent of the total revenue paid under a set-aside contract because the 50 percent limitation in FAR 52.219-14 applied only to labor costs and imposed no limitation on costs for materials or other direct costs. The NDAA appears to impose a “hard” cap on the amount that can be paid to a large business subcontractor and imposes stiff penalties for violation of that cap.

Subcontracting Plans

Under most government contracts awarded to other-than-small businesses, the contractor is required to submit a subcontracting plan establishing goals -- expressed in terms of percentages of total planned subcontracting dollars -- for the use of small business, veteran-owned small business, service-disabled veteran-owned small business, HUBZone small business, small disadvantaged business, and women-owned small business concerns as subcontractors. See FAR 52.219-9. This requirement must be flowed down to subcontractors. In recent years, there has been a perception that many large prime contractors and subcontractors are not doing enough to meet the goals established in their subcontracting plans.

To address this perceived problem, section 1653 of the NDAA provides that the failure of any contractor or subcontractor to comply in good faith with any plan required of such contractor “[s]hall be a material breach of such contract or subcontract that may be considered in any past performance evaluation of the contractor.” In addition, this section requires each agency to collect and report data on the extent to which contractors of the agency meet the goals and objectives in their subcontracting plans and to periodically review such data to ensure that contractors comply in good faith with their plans.

As a practical matter, section 1653 does not significantly change existing law. Prior to the NDAA, agencies were permitted to consider an offeror’s past achievement of its subcontracting goals as an evaluation factor. Moreover, FAR 52.219-9(k) already stated that a contractor’s failure to comply in good faith with its subcontracting plan constituted a material breach of the contract.

Section 1653 of the NDAA also adds a requirement that an offeror must notify a small business concern prior to identifying the small business concern as a potential subcontractor in a proposal or in a subcontracting plan submitted to the government. Separately, the SBA is directed to establish a reporting mechanism to allow any subcontractor or potential subcontractor to report fraud or bad faith conduct by a contractor with respect to its subcontracting plan. This provision will likely strengthen a proposed small business subcontractor's hand if, after award, the prime contractor does not honor its commitments.

Increased Penalties for Fraud and Creation of a Safe Harbor

Section 1682 of the NDAA appears to increase the likelihood that a contractor will be suspended or debarred for misrepresenting its status as a small business or subcategory of small business. Specifically, section 1682 removes the qualifying language of 15 U.S.C. §645(d)(2)(C), which stated that such a contractor could be suspended or debarred “on the basis that such misrepresentation indicates a lack of business integrity that seriously and directly affects the present responsibility to perform any contract awarded by the Federal Government or subcontract under such a contract.” The effect of removing that qualification remains to be seen.

While raising the severity of the penalties for fraud, section 1681 of the NDAA simultaneously creates a safe harbor for good faith compliance efforts. This section insulates from liability any contractor that acts in good faith upon a written advisory decision from a Small Business Development Center (“SBDC”) or an entity participating in the Procurement Technical Assistance Cooperative Agreement Program. SBDCs provide management assistance to current and prospective small business owners. The SBA has been directed to issue rules defining what constitutes an adequate advisory opinion for the purposes of this section not later than 270 days after the date of enactment of this section. Also, within the same 270-day period, the SBA Administrator must issue a compliance guide to assist companies in accurately determining their status as small business concerns.

In the past, most government contractors unsure about their size would have to wait until a post-award size determination (in response to a size protest) or government investigation to be certain of their size status for purposes of their potential liability for fraud in connection with a size representation. The new safe harbor advisory opinions will allow contractors proactively to seek early size determinations, which will help contractors confidently compete for contracts in good faith. These advisory opinions will be especially helpful given that the determination of a contractor’s small business status often involves interpretation of SBA’s affiliation rules, which do not always lend themselves to clear-cut applications.

Surety Bond Cap Increase

Under the Miller Act, construction contracts require the contractor to obtain a surety bond to ensure contract completion in the event of a default. Previously, the SBA could only help small business contractors by guaranteeing these surety bonds for contracts up to $2 million dollars. Through section 1695 of the NDAA, Congress has increased the contract maximum and now requires the SBA to guarantee surety bonds for any work order or contract that, at the time of bond execution, does not exceed $6.5 million. This increase will allow small business contractors to compete for larger construction contracts than they could have before by allowing the contractors to obtain larger bonds.

Removal of Contract Award Cap for Women-Owned Small Business Concerns

Section 1697 of the NDAA removes the contract award cap for women-owned small businesses. Prior to this change, contracting officers were permitted to set aside a contract for women-owned small businesses only if the anticipated award price of the contract, including options, did not exceed $5 million for manufacturing contracts and $3 million for all other types of contracts. This cap had greatly limited the number of women-owned small business set asides. The removal of this cap may result in an increase in the number of women-owned small business set asides.

New Requirements with Regard to In-Sourcing Decisions

Sections 1621 and 1691 of the NDAA seek to provide small business contractors some insulation from “in-sourcing” efforts by federal agencies -- that is, efforts by federal agencies to shift to federal civilian employees functions currently performed by contractors. Section 1691 states that each agency’s Director of Small and Disadvantaged Business Utilization (“DSDBU”) will review and advise regarding any in-sourcing decision pertaining to a small business concern. Section 1621, in turn, provides that SBA procurement center representatives must consult with the DSDBU of the particular agency and other agency personnel with regard to any decision to in-source any function performed by a small business concern.

Section 1655 of the NDAA also directs the Office of Management and Budget, within 270 days from the enactment of the NDAA, to publish procedures for federal agencies to follow in deciding whether to in-source functions currently performed by small business concerns. Through these new provisions, Congress has signaled a strong public policy against the in-sourcing of functions performed by small businesses.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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